Adding bonds to your portfolio: why and how?

Adding bonds to your portfolio: why and how?

This article is for anyone that is relatively new to the world of bonds and is considering allocating some of their account or portfolio to bonds, whether for:

• Earning higher returns on idle cash or deposits
• Diversifying some percentage of your portfolio with bonds of varying risk levels.

It should be noted that professional investors can use bonds as collateral for margin trading (up to 95% for the highest rated bonds). In all cases below, we only discuss bonds that mature in the 1-2 year time horizon as the safest place to operate in this market environment, given that shorter bonds offer the highest yields available at present and that central banks have yet to prove that they are winning their battle against inflation (i.e., bond yields could go higher still in the months and years to come if central banks have to hike rates even more than expected presently).

This article will offer:

• Perspective on the general yield levels that bonds can offer (as of early March 2023), from government securities widely considered to be “risk free” (more below) to low-risk investment grade corporate bonds and higher-risk high yield corporate bonds.
• A very brief introduction to the world of bonds.
• A few examples of what specific types of bonds are worth adding, depending on risk tolerance.
• For inspiration, one commonly used model to calculate the percentage of your portfolio that should be in bonds relative to your age and intended retirement date.
• How to trade bonds in Saxo’s platform.

For a more exhaustive primer on the world of trading and investing in bonds, have a look at bond-investing giant PIMCO’s guide.

What kind of returns can you expect from 1-2 year bonds?

The indications below for the yields available from shorter term bonds will fluctuate with market conditions and do not include transactions costs, which will depend on the size of the transaction and the liquidity of the bond in question (minimal costs for the most liquid instruments). By the way, in the month of February 2023, the US 2-year treasury yield rose approximately 0.60% and the German 2-year yield rose about 0.45%, to get a sense of how rapidly yields are moving during the recent time frame.

Note: all yields below are a snapshot made near March 1 of 2023 and subject to change as the market fluctuates.

1-2 year yields for USD-based investors

• US Treasuries: 4.8+% for a 2-year US Treasury
• Investment Grade US corporate bonds: approximately 5.25-5.50%
• High yield bonds:  6% and higher, depending on risk tolerance.
• Floating rate bonds: currently (as of March 2023) yield slightly less than 1-2 year bonds, but if central banks continue to hike as expected, the yield will move higher.

1-2 year yields for EUR-based investors

• “Risk-free” core EU bonds (Germany, France, etc..):  3.1% for 2-yr bonds
• Italian government bonds, or BTPs: 3.5% for 2-yr bonds
• Investment Grade EU corporate bonds: approximately 3.5%.
• High-yield EU debt: 4% and up, depending on risk tolerance.
• Floating rate bonds: currently (as of March 2023) yield slightly less than 1-2 year bonds, but if central banks continue to hike as expected, the yield will move higher from current levels.

1-2 year yields for DKK-based investors

• Danish government bonds:  near 3.2% for 1-2 year bonds
• Danish mortgage bonds: about 3.5%

What are bonds? A very brief introduction.

Bonds are a class of debt securities issued by governments and companies that typically pay out a pre-defined cash flow to holders, called its “coupon”. On their date of issuance, the vast majority of bonds have a maturity date, a date in the future when the bond holder will be reimbursed the full face amount of the bond. That face amount at maturity is called par and is expressed at a price of 100 for the bond, i.e., 100% of the face amount. A bond can trade both well above par and well below par depending on a number of factors, like the size and of its coupon relative to prevailing interest rates, the timing of the coupon payout, and the credit quality of the government or company issuing the bond and other factors.

There are an endless variety of bonds, for example those with coupons that “float” according to changes in the interest rates, inflation-linked bonds, short term bills that are issued below par and don’t pay a coupon, but mature at par, etc. It can all seem a bit daunting to investors not familiar with bonds, or “fixed income” as the professionals call them. But complexity shouldn’t scare investors away from investing in bonds. The vast majority of bonds worth buying for an investor looking for basic income and portfolio diversification, especially those with a medium or higher credit ratings, are quite straightforward in their risk- versus expected return profile. That is especially the case in the current environment of significantly positive interest rates, i.e., now that we have exited the zero- and negative policy rate era in most countries.

So you want to add bonds to your portfolio. What next?

–> Understand the risks

Short-term government bonds and bills (basically a short-term version of a government bond with special characteristics as described at the bottom of this section) are often termed “risk-less” as a default is considered largely inconceivable, but that doesn’t mean there is no risk in buying even government bonds.

Credit risk: The credit risk is simply the risk that the bond issuer fails an interest rate payment or to redeem the bond at face value at maturity. There is no real credit risk for sovereign debt that is issued in the currency of the sovereign. (Important to note the theoretical exception of all EU countries in the Monetary Union, especially the non-core, or “peripheral” Eurozone countries like Italy and Greece, as discussed below, as EU countries in the monetary union don’t have their own central bank and are in theory more at risk than debt issued directly by the EU itself.) There is a far more significant credit risk for countries issuing debt in a currency other than their own, for example in emerging markets, and for company-issued debt/bonds. Credit risk for companies is of considerable importance and can be considered very low or very high, depending on the strength of the company balance sheet in question. Yield levels relative to the lowest risk debt in a given currency usually reflect the level of credit risk for a company or country. There is also seniority to consider, as not only are debt holders paid in the event of a bankruptcy and liquidation before equity holders, but companies may have two or more levels of seniority in their debt structure, under which the most senior debt is paid first before more junior tranches of debt.

Interest rate risk: This is the risk that the interest rate rises after the purchase of the bond or bill and the market value of the bond falls, which could result in a capital loss if sold. For example, if you buy a German government bond with 1-year left until maturity at a yield of 3.00% and the 1-year German yield rises another 2% over the next three months, your bond would be worth about 0.7% less as a buyer can only be found for that bond if it yields an annualized 5% until the maturity date, assuming yields are the same for 9-months and 1-year. If held to maturity, the bond would still be redeemed at par, or 100% of the face value, but you would have earned more had you waited to buy the 1-year-to-maturity bond at the higher interest rate.

The longer the maturity, the more the market value is affected by interest rate risk. The opposite is the case if interest rates fall after you purchase a bond, which benefits the value of your position between the time of purchase and the maturity date and offers the opportunity to take profit and invest the funds elsewhere. Given that as of this writing in early March 2023, the highest yields available are at the short-end of the yield curve (with maturities of less than two years), most will want to lock in these yields rather than taking risks that yields continue to rise, especially longer yields. Of course, if longer yields collapse, for example because the world suddenly careens into a recession and disinflation investors would have missed out on the strong rebound in bond prices as yields fall, with the best returns for the longest bonds.

Inflation risk: This is the risk that inflation rises and impacts the real return of the bond investment, which is the return less the inflation rate. With inflation running very hot over the last year and more, most real returns on bonds have been negative, though if inflation falls back sufficiently in the coming six months, bonds’ real returns may soon return to positive territory (Current medium and longer term inflation expectations are lower than bond yields, but there is a risk that inflation stays high).. If inflation rises after the date of purchase, the real return of the bond will fall.

Liquidity risk: This is the risk that it is difficult and/or expensive to find a buyer of the bond an investor holds. This is mostly a non-issue for extremely liquid government bonds and bills, but becomes a more significant issue for riskier bonds and illiquid bonds that rarely trade. The bond’s liquidity risk is generally reflected in the width of the bid-offer spread when trading the bond, especially if you both buy and eventually sell the bond position rather than holding to maturity.

Currency risk: Currency risk is entirely avoidable for investors sticking to bonds issued in their own currency, but it can be a very significant two-way risk when buying bonds in another currency. Currency fluctuations will often prove far more volatile than the return on a bond, so currency risk should generally be avoided unless the investor has a view on the currency of the bond – not the intention here. Yes, currency exposure can be hedged in the currency market, and rather cheaply if the yields are similar between the home currency and the currency of the bond of interest, but can be very expensive when the yield in the currency of the target bond is significantly higher. As of this writing, for example, a Japanese investor buying a US treasury will lock in a slightly negative return on 1-year US treasuries (the generic term for US debt) in JPY terms if hedging the entire currency exposure and holding the treasury until maturity.

Call risk: Some bonds (mostly corporate bonds, but some floating rate bonds issued by governments have callable and/or “sinkable” features under which at regularly scheduled times, the bond issuer can call away the bond at par for callable bonds or buy it back at prevailing market prices if it is sinkable.

–> Decide on percentage of funds to allocate and choose an investment horizon.

First, decide what percentage of your funds you would like to shift into bonds and then decide on the intended time horizon(s) of the allocation to bonds. In the current environment of so-called inverted yield curves, for which high central bank policy rates relative to longer term bond yields, there for staying at the shorter end of the investment horizon, quite the contrary, as many central banks are expected to soon stop hiking rates and even begin cutting rates as soon as early next year (as of this writing). If making a more significant decision on the percentage of your portfolio to allocate to bonds on a longer term basis beyond the next year or two, or if making any significant investment decision, consult a professional investment adviser. One “rule of thumb” allocation model is in the appendix below as food for thought.

–> Determine which bonds to buy.

What to buy if only considering the lowest-risk bonds

USD investors: 1-2 year US Treasuries or T-bills*

EUR investors: 1-2 year core EU bonds (Germany, Netherlands, France, etc)

GBP investors: 1-2 year Gilts (UK Government bonds)

DKK investors: 1-2 year Danish Government bonds, 1-2 year Danish Mortgage Bonds

The table below offers specific ISIN numbers for shorter maturity government bonds and for Denmark, Danish Mortgage bonds, from those maturing in approximately six months to up to three years, depending on your currency region. Further below you can find links for instruction on how to find and trade these specific bonds in Saxo’s platforms - the easiest way is to simply copy and paste the ISIN number for the bond into the Instrument Search box in your Saxo platform.

What to buy if considering slightly higher yielding, but “investment grade” bonds.

Graphic of major bond ratings agencies' credit scale